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THERE IS EVIDENCE IN THE MARKETPLACE that volatility will continue to increase in 2008. Most likely, that increase will persist for a good portion of the year.

Even if this is a correct forecast, such an increase won't happen in a straight line. Volatility is -- well, volatile. The 20-day actual (historical) volatility of VIX (the Chicago Board Options Exchange Volatility Index) is often above 100%, and recently it has risen to some of the highest levels ever: the 50- and 100-day actual volatilities of VIX are near 140%! Thus, one can expect to see both peaks and valleys in volatility along the way. However, in the end, the trend of volatility will be higher.

There are two primary factors influencing this forecast: the level of volatility futures and the past path of interest rates.

Let's look at the volatility futures first. Volatility futures trade on the CFE -- the CBOE Futures Exchange. In essence, traders have priced the longer-term futures at high levels of volatility. The longer-term volatility futures are trading at prices above the VIX and nearly in line with near-term volatility futures. That is a construct that augurs for longer-term volatility to remain elevated.

If that is the case, then it is likely that short-term volatility (i.e., the VIX) will increase (a similar effect can be observed by looking at the premium levels on longer-term VIX options, traded on the CBOE itself).

The other influence behind the forecast of an increase in volatility is the level of short-term interest rates. There is empirical evidence that volatility generally tracks short-term interest rates, offset by two and a half years or so. [Figure 1 shows this relationship, comparing VIX with short-term interest rates, offset by 2.5 years.] The theory is that short-term interest-rate moves precede moves in volatility by about 2.5 years.

If this relationship holds, volatility is expected to increase throughout 2008, since short-term interest rates didn't peak until mid-2006, at the earliest. So, the peak in VIX isn't expected until at least 2.5 years later, or roughly the beginning of 2009. Note that this doesn't say anything about the magnitude of the increase in volatility. There is no direct correlation between the magnitude of the moves in rates and the corresponding move in VIX.

Does this mean we're going into a bear market for stocks? Not necessarily. As most traders know (or remember), the stock market was very volatile during the latter half of the 1990s, with VIX increasing into the 30s and even the 40s for most of 1999. However, that was also a bullish year, with the Standard & Poor's 500 index rising strongly on the year (despite a fall correction). So, an increase in volatility is not necessarily a harbinger of lower stock prices, although it often is: For example, in 2002, VIX ran from below 20 to near 45 while the stock market literally collapsed.

But in the modern world, we are no longer forced to try to turn a volatility forecast into a stock-market forecast. For now we have the ability to trade volatility products (futures and options) directly, and therefore it is possible to make money on volatility, regardless of the direction of the stock market.

LAWRENCE G. MCMILLAN is president of McMillan Analysis, a registered investment advisory specializing in derivatives research and money management.